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Network Goods and Network Effects

Consumers often place a higher value on a product or service if other consumers use it. When this occurs, the product/service exhibits network effects or network externalities. A network good is a good (product or service) that has higher value the more customers that use it. One person with a cell phone has limited value; however, if thousands have people have cell phones, the value of a cell phone network increases significantly: the more people who are connected, the more valuable the cell phone because more people can be contacted.

In some networks, consumers are physically linked; examples are cell phone and email networks. In these cases, the network effect arises because consumers can readily communicate with other users in the network. These networks are called actual networks. The more users in an actual network, the greater the opportunities for communication, and the more valuable the network becomes.

Virtual networks, in contrast, are those where consumers are not physically linked. In a virtual network, the network effect arises from the use of complementary goods or services. A computer operating system, such as Microsoft Windows, is an example of a virtual network. As the number of users of Microsoft’s Windows operating system increases, the demand for complementary goods, such as Windows-compatible software, increases. The increased supply and availability of Windows-compatible software, in turn, increases the value of the network. In a virtual network, users need never communicate with each other; as long as the collective buying power of the network encourages the supply of complementary products, each individual consumer benefits from being part of the network.

First movers benefit greatly from network effects. The firm that first establishes a large installed base of customers has a decided advantage in the market. Marginal customers, those consumers not already on the network, will observe the size of the network and tend to gravitate towards it. Thus, strategically, exploiting network effects offers a prime opportunity for first movers to develop a relative advantage in the marketplace, provided the first mover can develop a large installed base.

The converse of this is also true: that network effects can be a powerful barrier to entry for rival firms wishing to challenge the network incumbent. Ownership of a network good can be incredibly valuable because entry against an established incumbent is difficult. When a network effect is present, a large market share creates an advantage much like an economy of scale – entrants have a difficult time overcoming the value created by the large number of users in the network.

Networks, by their very nature, tend to create switching costs which serve to lock-in customers. Switching costs are the costs consumers experience by changing brands. If, for example, consumers have opted to run Microsoft Windows and use Windows-compatible software, there will be a significant costs, in terms of time and money, to switch to a competitive operating system and compatible software. Firms can intensify customer lock-in by basing a network good on proprietary formats or standards which are incompatible with rival products and services, thereby increasing switching costs. Customer lock-in can also be increased by upgrading, at relatively modest cost, inframarginal customers (those customers already on the network) to enhanced capabilities or features offered in the network good.

An important strategic question for providers of network goods is the extent to which complementarities can be exploited. Complementarities, or synergies, can be exploited in several ways. The first is to ensure that the elements of value which make up the network good in question are coherent – that each of the value elements fits with the others and thus reinforces and multiplies the total effect. Thus, the value elements making up a network good must be wisely chosen and designed so that the level of coherence is high. The second way to exploit complementarities is through the provision of complementary third-party goods and services. Integrating complementary third-party goods and services into a network good can significantly increase the total value being offered. At the same time, if the supply of these third-party goods and services are secured under and exclusive agreement, a significant barrier to imitation and entry can be erected.

The promise of profits from network goods often leads to intense competitive rivalry which can become a war of attrition. Where competing network goods are vying for customers, such as happened in the VHS versus Beta video wars, potential customers often look to market share as the key indicator of who is likely to win. Because the firm with the larger market share is perceived as the one more likely to win the competitive battle, the firm with the larger share possesses a relative advantage in the marketplace. In this case, a large market share may be a self-fulfilling prophecy of success.